BOND MARKETS

1
CHAPTER 8

• BOND MARKETS

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Capital Markets

• Economic purpose -- brings together long-term
  (over 1 year) borrowers and long-term investors.
• Major Issuers (borrowers)
• Households - mortgages.
• Business bonds and stock
• Governments -- federal, state, and local bonds.
• Major Investors
• Households (directly or indirectly through
  financial intermediaries).
• Foreign investors.

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Economic Sectors
4
Capital Market Instruments Outstanding
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Types of Capital Market Claims

• Corporate stock -- studied in Finance 311 and
  Chapter 10 of this text
• Bonds -- studied here in Chapter 8
• Mortgages -- studied in Chapter 9

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U.S. Treasury and Agency Securities

• U.S. Government Issues -- Notes and Bonds
• Coupon issues.
• Notes -- one to ten-year maturity.
• Bonds -- over ten-year maturity.
• Sold by auction by the Federal Reserve banks.
• Trend is toward more money market financing and
  less capital market financing.
• The book reports that the 10-year Treasury note
  has become the benchmark security.

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U.S. Treasury Securities

• Treasury Inflation Protection Securities (TIPS)
  adjust for inflation
• First issued in 1997
• Separate Trading of Registered Interest and
  Principal (STRIPs)
• A treasury security that has been separated into
  its component parts Interest and Principal

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Corporate Bonds

• Debt contracts (indenture) requiring borrower to
  make periodic (typically semi-annual) payments of
  interest and repay principal, usually 1,000, at
  maturity date.
• Types of ownership record
• Registered bonds -- owner noted by records.
• Bearer bonds -- coupon bond owned by bearer.
• Maturity
• Term bonds -- all bonds mature at future date.
• Serial bonds -- bonds mature at varying future
  dates.
• Usually Municipal Bonds

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The Bond Indenture

• Collateral
• Mortgage bond -- real assets pledged.
• Equipment trust certificates -- specific, titled,
  or identifiable equipment.
• Collateral Trust bonds -- secured by financial
  assets.
• Debentures -- unsecured bonds.
• Claim on assets
• Senior debt -- first priority to general assets.
• Subordinated -- asset claim ranking of unsecured
  debentures below senior or specific general
  creditors.

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The Bond Indenture (concluded)

• Means of principal payment
• Sinking fund
• building a sum for retirement
• the periodic retirement of a number of bonds
  selected randomly.
• Call provision -- borrower right to retire bond
  before maturity.

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Investors in Corporate Bonds

• Major investors include
• Life insurance companies.
• Pension funds.
• Bond Funds
• Households.
• Foreign Investors.
• Investor requirements
• Long-term investment horizon.
• Liquidity not always needed -- hold to maturity.
• Safety -- investment grade.
• Tax considerations.

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Market for Corporate Bonds

• Public sale -- open to all interested buyers.
• Competitive sale -- public auction among
  underwriters.
• Negotiated sale -- underwriting contract signed
  with specific underwriters.
• Shelf Registration
• Role of Investment Banker(s)
• Most secondary trading of corporate bonds occurs
  through dealers vs. exchanges.
• the volume of trading is low--a thin market,
  thus there is a wide bid/ask differential in the
  market.
• corporate bonds are less marketable than money
  market instruments.

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Market for Corporate Bonds - Concluded

• Private placement -- sold to limited number of
  sophisticated buyers, avoiding SEC registration.
• private placements have increased relative to
  public sale.
• when interest rates are high and/or when capital
  market conditions are unstable, private
  placements increase.
• SEC Rule 144a (1990) liberalized the regulation
  of private placements. It allows secondary market
  trading of private placements.

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Securitized Obligations

• Securitizing a pool of loans that permit separate
  claims on principal and interest
• Asset-backed securities
• Payments on a pool of loans can be divided into
  tranches.
• Collateralized Mortgage Obligations
• The exact day on which all principal will be
  repaid has become uncertain
• Automobile Loan-Backed Securities
• Consumer Credit Card Receivables

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Junk bond issuance was very popular in the late
1980s

• Junk bonds are low rated (high default risk - Ba
  or below) corporate bonds.
• Development of the junk bond primary market was
  enhanced by the secondary market maintained by
  Drexel, Burnham and Lambert in the early 1980s.
• Higher risk firms found they could issue longer
  term, more flexible securities in the high-yield
  market rather than borrowing from commercial
  banks.

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Junk bond issuance was very popular in the 1980s
(concluded)

• Many financial institutions, such as SL's and
  life insurance companies, with high cost sources
  of funds, became major junk bond investors.
• Junk bonds fueled the merger mania of the 1980s.
• Junk bonds are still used. In essence, they are
  an alternative to bank debt.

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State and Local Government Bonds -- Municipal
Bonds

• Types of Municipal Bonds
• General obligation -- backed by taxing power of
  political entity.
• Revenue -- financed and paid back from a specific
  project (such as the Southern Connector).
• Industrial development bonds (IDB) -- public
  financing of private business.

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State and Local Government Bonds -- Municipal
Bonds, cont.

• The Relation between Municipals and Taxable
  Yields
• Interest on municipal bonds is exempt from
  federal tax on coupon interest payments.
• Muni-bonds and taxable corporates are similar
  except for the taxation of interest.
• The yield on municipals equals the yield on
  taxables times one minus the marginal tax rate.
  iat ibt (1-T).
• Tax Equivalent Yield (TEY) iat divided by
  (1-T)

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Corporate vs. Muni Bond

• An investor has the choice of a Aa rated
  corporate bond with a yield of 6 or a Aa rated
  muni-bond yielding 4. If the investor has a
  marginal tax rate of 30, which bond should
  he/she select?

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Corporate vs. Muni-Bond

• The after-tax rate on the corporate is
• 6(1 - .3) 4.2 gt 4 muni bond or
• The pretax equivalent rate on the muni bond would
  be 4/(1 - .3) 5.7 lt 6 corporate
• Select the corporate bond!

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State and Local Government Bonds -- Municipal
Bonds, cont.

• Three groups of investors in municipal bonds
  whose demands are affected by their high federal
  tax exposure are
• Households -- affected by income level and
  marginal tax rates.
• Casualty insurance companies -- investment
  determined by industry profitability.
• Commercial banks -- the Tax Reform Act of 1986
  ended the tax deductibility of interest expense
  incurred on borrowing for the purchase of tax
  exempt securities.

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State and Local Government Bonds -- Municipal
Bonds, cont.

• The Market for Municipal Bonds
• Primary market.
• Many individual smaller issuers.
• Underwritten by investment bankers--from local to
  national markets.
• Secondary market not well-developed -- OTC market
  made by dealers.

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The Role of Financial Guarantees

• Cover the payment of principal and interest in
  the event of default.
• Substitutes the credit standing of the guarantor
  for that of the security issuer.
• Provided for a fee by
• Insurance companies - insurance policies to back
  bond issues. (e.g. MBIA)
• Commercial banks - letters of credit to back
  commercial paper or swaps.

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Global Bond Markets

• EURO Bonds
• Foreign Bonds
• Yankee Bonds
• Samurai Bonds
• Bulldog Bonds

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Conclusion

• Capital Market
• Instruments
• Corporate Bonds
• State and Municipal Bonds
• Government Bonds
• Federal Agency Bonds
• Participants
• Households
• Business
• Governments
• Foreign Investors